Description

AMBC, Ambac Financial Group, a monoline insurer in its past life, emerged from bankruptcy last month, after three years of being in rehabilitation thanks to the subprime RMBSs it insured before the financial crisis. As it stands, the company operates as a runoff. Per most recent 10Q it is …actively managing its assets and liabilities with a focus on maximizing investment portfolio returns and mitigating or remediating losses on poorly performing transactions, including through executing policy commutations, repurchasing liabilities at a discount, pursuing recoveries of losses through litigation and the exercise of contractual and legal rights, and restructuring transactions.

With very limited research coverage from the Street due to the firm’s recent reemergence with no clear business direction to talk of, significant value is being overlooked by the market and is likely to be in mid $30 handle, meaningfully north the currently observed ~$25. The value comes from two main sources:

1. Recoveries of losses resulting from counterparties’ breaches of reps and warranties (R&W) on securitized mortgages insured by AMBC
2. Potential utilization of more than $5bln of NOLs, translating into ~$35 per share of taxes the co won’t have to pay on its future earnings

The policy commutations (mentioned in the 10Q excerpt above) may end up being a significant source of value too. However, let’s ignore them now, since company reporting in this matter has been very scarce, and it’s unclear what opportunities there are in this arena. Suffice it to say, these commutations will only be undertaken if they add value and thus constitute an option for the company.

The R&W recoveries alone, with reasonable recovery rate assumptions, can more than justify current market cap and provide near- to-medium-term catalysts for the share price.

The largest recoveries sought are from Countrywide/BAC. Of the $2.5bn of overall Breached R&W losses indicated by the co, $1bn are attributed to Countrywide in the recently updated complaint. Countrywide/BAC litigation is also the most likely to be resolved sooner rather than later, as BofA is trying to put most of the Countrywide related legacy issues behind it.

The crux of AMBC’s litigation is quite similar to the recently resolved MBIA’s case against Countrywide and can be crudely summarized as follows:

a) Countrywide misrepresented everything there was to misrepresent about the quality of the mortgages that it securitized

b) AMBC insured the securitized mortgages relying on Countrywide’s false representations

c) Ambac sustained crippling losses as the mortgages massively defaulted during the housing crisis

d) BofA is responsible for the losses having bought Countrywide

Likelihood and timing of successful resolution

Looking at Ambac’s R&W recovery pursuits (especially against BofA), through the prism of the recent success by MBI against the same counterparty, it’s hard not to be optimistic. Before BofA finally decided to settle with MBIA a month ago, the judge in the case made critical plaintiff-friendly rulings on several issues, e.g.  Successor Liability (i.e. what is BofA’s responsibility for Countrywide’s liabilities), Loss Causation ( i.e. whether there is a need to tie specific claims payments to particular misrepresentations), Statistical Sampling (i.e. whether conclusions can be extrapolated to the entire set of loans by proving fraud in only a small sample), etc.  All of these provide powerful weapons for AMBC in its upcoming battle and are likely to induce BofA to initiate settlement talks, accelerating the catalyst for AMBC stock.

Another accelerating factor is the fact that the presiding judge (Judge Eileen Bransten) is the same judge that issued those rulings in the MBI litigation above. She is obviously very familiar with the issues and has displayed leanings favorable to the plaintiffs, further motivating BofA towards timely settlement.

Besides just improving Ambac’s chances, these precedents also make many of the time-consuming pre-trial steps unnecessary, thus shortening the timeline of this litigation, that is, if settlement talks don’t resolve everything sooner.

Finally, in a less likely (but not unrealistic) scenario, the ongoing widely-covered litigation challenging the 2011 $8.5bln settlement between BofA and mortgage securities investors can accelerate the AMBC case timeline as well. If the disputed $8.5bn settlement is seriously jeopardized, BofA may be motivated to quickly settle the AMBC litigation. Dragging its feet with MBI already created precedents used by AMBC and other parties against it. If the $8.5 bln is blown up, unleashing many new plaintiffs and lawsuits, the last thing BofA would want is to arm them with new, more powerful successor liability and other precedents coming from the prolonged AMBC litigation.

The magnitude of the recoveries

Looking at recent precedents and AMBC’s financial statements, we can expect a range of recoveries that alone could outstrip the current market cap of $1.17bn. The co. indicates $2.5b of losses it aims to recover in the Breached R&W litigations. $1b of it was stated in the Countrywide complaint. The obvious fair question is “How much of this can be recovered?” But given that the $1bn figure refers to the losses sustained prior to the 2011, another critical question is “what were the Countrywide-related losses sustained between the filing time and now?” Clearly, the losses did not stop at the point of the filing, and may have even accelerated for some time. We don’t know what they amounted to, but they are likely to be meaningful.

Looking at the Ambac’s litigation against Credit Swiss as guidance, according to the Feb 2010 complaint, by that date Ambac made over $44m in claim payments on the CS-issued securities with breached reps and warranties. On March 1^st 2013 AMBC and CS settled. How much did CS pay? In the most recent AMBC’s 10Q, the RMBS subrogation table indicates a $54m reduction from the “impact of sponsor actions,” where sponsor actions include “loan repurchases, direct payments to Ambac, and other contributions from sponsors.” This also corresponded to a reduction of 2 RMBS transactions from the 22 for the prior quarter. This must be coming from the CS settlement, as there have been no other settlements in Q1 to talk about.

Where is the difference between $44m lost in 2010 and $54m recovered in 2013 coming from? The difference is attributable to the losses from incremental claim payments made by AMBC to CS in the 3 years after the filing of the complaint. Those incremental losses were likely incurred at an accelerating rate, since more and more loans defaulted as the crisis worsened.

We can only guess what the total CS loss amount was and what the agreed upon recovery rate was in settlement, but the bottom line is, they recovered MORE than the $44m originally mentioned in the complaint. 25% more (almost certainly implying the total loss nearly double the original amount and a likely recovery rate somewhere north of 60% on the total loss).

Applying similar logic to the Countrywide case, given similar timeframes of the two complaints, it’s not unreasonable to expect recoveries not far from the $1bn amount, if not more, given that the losses must have continued to pile up significantly above the original $1bn figure in the housing collapse aftermath for 2 years after the complaint’s filing.

Beyond the Countrywide case, with the currently targeted $2.5bn total recovery amount potentially evolving this way into a much larger number, there’s a significant upside likely to become visible as AMBC’s wins or settles its upcoming cases against BofA and other counterparties (JPM, First Franklin, CapitalOne and Nomura)

Finally, there’s an additional source of upside in the R&W recoveries side of the story. AMBC has been quite late in the game initiating their lawsuits against their counterparties. From their recent 10Q, losses from only 46% of their policies have been addressed in the suits seeking the $2.5bln we keep discussing. The other 54% of the policies have their corresponding portion of the AMBC’s $6bln loss reserve, ($2bln+ of losses, in fact), but no lawsuits were filed for those yet, and no expected recoveries have been priced in. Any new lawsuit addressing those losses, assuming even the most conservative recovery rates, will create further positive catalysts increasing potential recoveries.

That brings us to the NOL’s. While part of the $5bln can be unlocked against the taxes on any of the above-mentioned recoveries, most of the NOL’s value can only be materialized through a new cash-flow positive business the company plans to enter eventually. Listed as one of the two shareholder value maximizing strategies in their 10Q is

In their recent communications with the Street AMBC went out of their way to indicate that in their search for a new business they are moving away from insurance model and are actively considering other financial services directions. This may indicate the company is not sitting on its hands with an abstract goal of establishing a new business with an open-ended timeline, but rather may now be exploring something more concrete and is undertaking steps in a new direction.

Looking medium term, the company benefits from the ongoing housing recovery, as lower realized default rates reduce future losses stemming from claims. Recent financial statements point to a loss expense reserve of $6bn+.  This figure is priced in by the market and any reduction due to improving economic conditions should be favorably reflected in future valuation.

Lastly, looking at the immediate technical catalyst, AMBC is eligible for inclusion into Russell 2000 index in the end of the month. Close to 4m shares would need to be bought by the indexers during the reconstitution, providing a meaningful boost to the share price.

Management of the company has been difficult to reach, and it is unclear how executives are incentivized and what the composition of their compensation packages is. One would assume, given low cash generation in the company, it would be meaningfully weighed towards stock awards. Hopefully this information will be released in the next 10Q, but until then we cannot discount a risk of management pursuing some dilutive transaction if their interests are not properly aligned with those of the shareholders.

I do not hold a position of employment, directorship, or consultancy with the issuer.

I and/or others I advise hold a material investment in the issuer's securities.
This investment may change at any time.

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